mREIT valuation & interest rate risk

In today’s hunt for yield mREITs seem to be an increasingly popular choice. The sector offers yields in the range of 13%. With even high yield bonds trading down to yields of ~7% an almost doubling of potential yield is compelling. But have investors chased yield too much and what happens if rates change dramatically? Today I want to do a check on the valuation of mREITs in general and look at the potential impact of changing interest rates on the business.

First, lets take a look at valuation. I’ve covered mREIT basics on the blog before so if you’re unsure of some of the basics you can go back and review. The best metrics for mREIT valuation are price to book value (P/B) and dividend yield. I last posted on mREIT valuation in Oct of last year. In that post, the group of large cap mREITs that I follow was trading at a P/B of 0.88 and an average yield of 18.7%. These were pretty attractive valuations as I mentioned at the time. Well, since then mREITs have had a real nice run as mortgage rates continued to fall. See the chart of the mREIT ETF (MORT) below.

Not bad. mREITs are up about 30% since last October not including dividends at all! Hopefully you got in on some of these gains. So, where are we today? Below is my revised table, as of Q2 2012, of large cap mREIT valuation.

I’ve swapped out one mREIT in my tracking portfolio. I’ve replaced CIM with TWO due to the accounting uncertainties involving CIM and the growth of TWO above a $1B market cap. The mREIT portfolio is now trading at a P/B of 1.1 and a yield of 13%. On a P/B basis I would say the sector is at an average valuation compared to history but is trading at a lower dividend yield than the past. This is not too surprising given historically low rates. Based on these valuation metrics I wouldn’t be looking to take any big long positions in the space right now. The big run is probably over.  Shorter term investors can probably look to trade the upcoming Q3 dividend announcements but longer term investors would probably be better off looking in other sectors. There are better valuations and higher total return potential in other sectors, e.g. MLPs. Of course, mREITs could go up more especially with any new FED interventions such as QE3. The big question would be how much QE3 have mREITs priced in already? Which brings up the potential of big interest rate changes.

In this interest rate environment a critical consideration when owning mREITs is their exposure to changing rates. As I mentioned in my mREIT interest rate risk post, every mREIT publishes the potential impact of changing rates on their book value and net income in their quarterly SEC filings. Its takes a bit of time but it is not difficult to find the data. Below is the Q2 2012 data from the 10-Q filings for the mREITs I track.

BV stands for book value and NI stands for net income change. A change in book value will impact the stock price and a change in net income can signal changes to the dividend. These metrics are there to give you a gauge of risk and do not foretell exactly what would happen in a rising or falling rate scenario. The data is based on models assuming parallel shifts in the interest rate curve for example. That rarely happens in reality. Nonetheless, you can get a pretty good read as to how exposed a particular mREIT is to changing rates. Combining these interest rate metrics with the valuation figures discussed above can give an investor value edge in making an investment decision. For example, when taking in all this data I like NLY’s positioning and relative valuation among all the mREITs. Given my view of rates, which is that they remain low (discussed here and here), NLY is my favorite pick in the sector especially on any pullback.

In summary, the mREIT space has had a great run over the last year and seems to be fairly valued now while offering below average yields relative to history. Of course this is true of many if not most high yielding sectors today. Investors can use the typical valuation metrics of P/B and dividend yield combined with readily available interest rate risk metrics to make better investment decisions regarding reward for risk taken.